Energy-subsidy reform is notoriously difficult. This column argues that the environmental and social payoff from a concerted worldwide effort to replace these subsidies with better targeted measures would be substantial. Subsidy reform is an especially attractive option for countries under pressure to bring public debt to more prudent levels. The success of reform in several countries shows that the challenge is not insurmountable.

There are many reasons that economists don’t like energy subsidies. They’re expensive, they hurt the environment by promoting excessive consumption of energy, and they do a bad job of helping the poor because they tend to benefit the most those that need it the least (International Energy Agency 2011; the Organization for Economic Co-operation and Development 2009, 2012; World Bank 2010). Yet, despite a strong economic case for their elimination, governments have found it difficult to do so. In a recent study, however, we find that a well-designed strategy can reduce subsidies and win public support (IMF 2013). This can open the door to a better use of public resources and a cleaner environment.

What is not well recognised is that energy subsidies are an issue in both developing and advanced economies. Pre-tax subsidies, which arise when energy consumers pay less than the supply cost of energy, are high in many developing economies. Although pre-tax subsidies are not very prevalent in advanced economies, they have large tax subsidies. These arise when:

Energy is taxed below the rate of other consumption goods.

Energy taxes are not high enough to capture the negative externalities from energy consumption – including the effects on climate change, local pollution, and traffic congestion.

Based on a newly assembled dataset on energy subsidies – the most comprehensive to date – global energy subsidies are huge. In 2011, they are estimated at $1.9 trillion, the equivalent of over 2.5% of world GDP, or 8% of all government revenues.

The case against subsidies revisited

The adverse effects of energy subsidies go well beyond their impact on fiscal balances:

Energy subsidies reinforce inequality.

The largest beneficiaries are upper-income households, who are the largest consumers of energy. On average, the richest 20% of the population in developing economies captures six times more in fuel subsidies than the poorest 20% (see figure). There are better options for raising the living standards of the poor than keeping the price of energy artificially low, such as well targeted social programmes.

They depress economic growth.

Low and subsidised prices make it unattractive for firms to invest in the energy sector and crowd out growth-enhancing public spending, including for infrastructure, education, and healthcare. Furthermore, they result in the misallocation of resources to capital and energy-intensive activities.

Subsidies damage the environment.

We estimate that eliminating energy subsidies, including tax subsidies, would lead to a 13% reduction in energy-related carbon-dioxide emissions. Reducing subsidies would also have a favourable effect on local pollution, as well as traffic accidents and congestion.

Figure 1. Distribution of petroleum-product subsidies by income groups (percent of total product subsidies)

Source: Arze del Granado and others, 2012.

The size and scope of energy subsidies

Energy subsidies are pervasive. Based on data for 176 countries, pre-tax subsidies for petroleum products, electricity, natural gas, and coal are estimated at US$480 billion in 2011, some 0.7% of global GDP. Almost half of subsidies are for petroleum products. The Middle East and north Africa region accounts for about half of pre-tax subsidies, where they are estimated at 8.6% of GDP and 21.8% of government revenues.

The story is different when we also take into account tax subsidies. We find that the latter subsidies are three times the size of pre-tax subsidies. Advanced economies account for 40% of the total (both pre- and post-tax subsidies), with the US, China, and Russia being the top three subsidisers in absolute terms. As a share of regional GDP, however, post-tax subsidies are roughly eight times larger in the Middle East and north Africa than in advanced economies.

Figure 2. Subsidies by region

Source: International Monetary Fund (2013).

Figure 3. Subsidies by product and region

Source: International Monetary Fund (2013).

Key ingredients of successful energy-subsidy reform

Energy-subsidy reform is difficult but not impossible. Based on the reform experiences in 19 countries, we find six key elements for success for eliminating pre-tax subsidies:

A comprehensive and detailed reform plan.

This should include clear long-term objectives, such as achieving price liberalisation and improving quality of services. There should also be an analysis of the winners and losers of reform, which can help guide the design of mitigating measures.

A far-reaching communications strategy.

This involves informing the public of the size of subsidies and the potential benefits of subsidy reform, for example, the scope to raise priority spending in social sectors.

Mitigating measures to protect the poor.

Targeted cash or near-cash transfers in lieu of subsidy, such as vouchers, is the preferred approach. If this option is not feasible, the focus should be on existing targeted programmes that can be expanded quickly, such as school-based or maternal and child-feeding programmes and subsidised mass transit.

Appropriately phased and sequenced price increases.

More phased increases provide household and firms time to adjust, and allow the government time to build credibility by showing that subsidy savings are being put to good use.

Improving the efficiency of SOEs to reduce their fiscal burden.

This can be accomplished by improving information on their costs, and based on this information, setting performance targets and incentives.

Depoliticising energy pricing.

The introduction of automatic pricing mechanisms, governed by an independent body, can help insulate energy pricing from political pressures and make reforms durable.

What can be done to reform tax subsidies for energy? The ingredients for reform will be broadly similar. For example, governments will need to build consensus on the advantages of raising taxation on energy and the resulting scope for lowering other taxes (such as taxes on labour) and increasing spending. Some examples of reform in this direction are Germany, where a comprehensive environmental-tax reform was introduced in 1999, with about 85% of the new revenues offset by a reduction in labor taxes; and Australia, where a carbon-trading scheme will be implemented in 2015, with half the revenue to fund social welfare payments and an increase in personal income-tax thresholds.

Conclusions

Energy-subsidy reform is a challenge throughout the world. The payoff from a concerted worldwide effort to replace these subsidies with better targeted measures would have substantial benefits for both the environment and, if accompanied by better targeted support, the poor. Subsidy reform is an especially attractive option for countries under pressure to bring public debt to more prudent levels. The success of many countries shows that the barriers to reform are not insurmountable. Renewed efforts to reform subsidies would be well worth it.

References

Arze del Granado, Javier, David Coady, and Robert Gillingham (2012), “The Unequal Benefits of Fuel Subsidies: A Review of Evidence for Developing Countries”, World Development 40, November, 2234–48.